From SCDigest's On-Target e-Magazine

Wages will be up 80% in Five Years, Li & Fung CEO Says; Vicious Cycle of Inflation and Wage Hikes; Western Consumption Patterns to Change?

SCDigest Editorial Staff

Rising wages in China over the past few years have already started to have some impact on the China offshoring decision process, with some apparel makers moving out of China to other Asian locations already, and other companies looking westward in China trying to chasing lower costs.

But Western companies may not be well prepared for even higher cost increases coming.

That from a man who ought to know - William Fung, CEO of trading giant Li & Fung, which manages sourcing programs from China and elsewhere in Asia for hundreds of companies from its headquarters in Hong Kong.

SCDigest Says:

Chinese workers are now three times more expensive than their Indonesian counterparts, and five times as costly as in Vietnam on a pure wage basis, without considering productivity.

What Do You Say?

In a recent interview, Fung says that he predicts China's wages will increase an amazing 80% over the next five years - significantly changing the cost dynamics for sending production to China.

It is also among the reasons the Chinese government is making aggressive efforts to move the country into more complex, higher value goods that have a lower labor cost as a percent of total costs.

"What we [China] will have for the next 30 years is inflation," Mr. Fung said. "A lot of Western managers have never coped with inflation."

With its huge population and millions of people moving into eastern cities from rural areas, China for most of the last decade had ample supplies of workers even as production and export levels surged. Unionization is illegal in China other than pseudo-unions tied to the government, and workers rights have generally been extremely limited.

But some of that is starting to change. Fung says that worker shortages will start to be seen, as the impact of China's "one child" policies meant to reduce population growth that were enacted decades ago start to have a demographic effect.

Some observers say there's already a shortage of workers in the key 15 to 34 age demographic. Jun Ma, Deutsche Bank's chief economist for Greater China, says that cohort has been steadily declining since 2007, and that it will get worse. That will push wages up not only because of demand-supply dynamics but because wages will need to rise for existing workers to support a rapidly growing retiree population.

Chinese wages also took a sharp turn upward last year, as unusual strikes and other labor actions in 2010 drove a number of companies to raise wages 20-30%, and local provincial governments to do the same on minimum wages last year.

In February of this year, the mayor of Shanghai, has just delivered a pleasant surprise to the city’s workers by announcing an increase in wages of more than 10% starting in April. That followed a 30% increase in the minimum wage in Beijing in January.

Fung calls this the "Foxconn effect," referring to the electronics outsourcing giant that makes Apple iPads and dozens of other products for Western manufacturers. Following a string of worker suicides last year at one of its China factories, which called into question Foxconn's treatment of its workers, the company raised wages some 30% there.

High levels of inflation in China, driven by economic growth and rising commodity prices, place further pressure on the government and companies to increase wages to keep up, leading potentially to a vicious circle other economies have faced where rising wages perpetuate an inflationary cycle. China's inflation rate has been above 5% on an annual basis in both March and April of this year.

Finally, China's efforts to keep the value of the Yuan low to pump up exports in turn leads to higher prices for its imports, adding to the pressure on inflation and wages.

Moves further inland, however, could blunt some of this effect for awhile. For example, Foxconn recently announced it was expanding operations to inland areas near Chengdu, Wuhan, and Zhengzhou, away from its existing coastal base. Those moves are not without some risks, however, and logistics complexity and costs will rise. Capacity could be an issue if China's domestic market continues to grow, as output from the more inland factories is largely soaked up by in-country demand.

“The utopia for one stop sourcing for quality and low price has been China, but utopias never last,” said Matt Rubel, CEO of Collective Brands, the US footwear group that owns the Payless shoes retail chain, earlier this year. Rubel says the company is shifting a some production from China to Indonesia because of rising costs in China.

Chinese workers are now three times more expensive than their Indonesian counterparts, and five times as costly as in Vietnam on a pure wage basis, without considering productivity. But with wages rising much faster in China than other Asian markets, it is clear companies will increasingly look elsewhere - including "near shoring" - instead of China.

Rising wages in China are not only affecting Western companies directly or indirectly producing there. Fung , for example, says that Li & Fung has been hired by major Chinese sneaker brand Li Ning Co. to help it search for cheap production outside China.

The result: the wage gap between China and other developing countries will shrink, Fung says, adding that the damper China has put on price increases generally over the past decade is ending.

"Things will be more expensive and people will buy less," Fung warns, saying that the West will have to adopt new consumption trends.

Are you seeing/feeling pressure from rising labor costs in China? How do you see this playing out? Let us know your thoughts at the Feedback button below.